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IMF Executive Board Concludes 2017 Article IV Consultation with Nepal

March 27, 2017

The Executive Board of the International Monetary Fund (IMF) concluded
the Article IV consultation
1
with Nepal on March 27, 2017, and considered and
endorsed the staff appraisal without a meeting on a lapse-of-time
basis.
2

Nepal’s economy is rebounding following a slowdown caused by the 2015
earthquakes and trade disruptions at the southern border. The growth of
real GDP at market prices slowed to 0.6 percent in 2015/16 (mid-July
2015 to mid-July 2016). Shortages of fuel and other essential goods due
to the trade disruption drove up inflation to 12 percent (y/y) in
January 2016, but eased subsequently to 3.2 percent in January 2017,
mainly on account of lower food prices.

Budget under-spending worsened in 2015/16. At the same time, revenues
exceeded the budget due to one-off telecom sector collections. As a
result, the budget was in surplus for the fourth year in a row and net
public debt declined further to 22 percent of GDP, down from 34 percent
of GDP in 2011/12.

Private sector credit growth surged to a 7-year high of 31 percent
(y/y) in January 2017.

The current account surplus reached 6.3 percent of GDP in 2015/16 on
account of lower imports from the trade disruption. Exports also
suffered. The growth rate of remittances slowed sharply, to 1 percent
in 2015/16, from an annual average of 15 percent during the previous 5
years, due to weak growth in oil-producing host countries. Gross
reserves of the central bank reached a record US$8.7 billion, covering
more than nine months of imports, in January 2017.

Growth is projected to reach 5.5 percent in 2016/17 and inflation is
expected to undershoot the central bank’s mid-2017 target of 7.5
percent.

Nepal’s economy is rebounding following a slowdown caused by the 2015
earthquakes and trade disruptions. The normalization of economic
activity is supported by a good monsoon, accommodative monetary policy,
and rising government spending. Inflation has been decelerating due to
base effects related to last year’s trade disruption but is expected to
remain above India’s inflation. More recently, the authorities have
also been able to advance reforms in a number of areas.

The medium-term outlook critically depends on efforts to sustain and
deepen the nascent reform momentum. Stronger policies are needed to
enhance confidence amid ongoing political uncertainty. They are also
needed to strengthen key institutions and administrative capacity,
which are critical for overcoming poor service delivery and chronic
under-implementation of the budget, and for boosting private investment
and growth. Accordingly, in the absence of stronger policies, and
taking into account the lower projected growth of remittances and the
effects of the earthquakes and trade disruption, growth would likely
fall below the average of the past decade and fall short of what is
needed to substantially improve living standards and social indicators.

Risks to the outlook are broadly balanced. The rebound in economic
activity could be more pronounced and persistent than set out in the
baseline, particularly if the momentum in policy and structural reforms
is sustained and deepened. Key downside risks pertain to domestic
political instability, the weak financial sector, slowing remittances
impacting financial sector liquidity, and lower growth in India due to
the demonetization shock.

To support Nepal’s recovery while maintaining macroeconomic and
financial stability, the macroeconomic policy mix should be rebalanced
toward a more accommodative fiscal position and a tighter monetary
stance. Staff welcomes the authorities’ plans and efforts to scale up
government spending to rebuild after the earthquakes and address
infrastructure gaps to boost medium-term growth. In view of the limited
implementation capacity, it will be essential to have a realistic
budget that effectively prioritizes spending to maximize growth
dividends, including in social spending areas most important for
inclusive growth. The scaling up of government spending should not
exceed the economy’s aggregate absorptive capacity and should be
anchored in a medium-term expenditure framework to ensure quality and
fiscal sustainability.

The monetary policy framework needs further strengthening. Staff
welcomes the introduction of an interest rate corridor. Next steps
would involve refining the framework by fixing the floor of the
interest rate corridor to reduce the volatility of interbank interest
rates and adopting a medium-term inflation objective consistent with
eliminating the inflation wedge with India on a sustained basis. With
remittances set to slow, fiscal policy turning expansionary, and the
current account turning to a deficit, a tightening of monetary policy
is needed to prevent the exchange rate from becoming somewhat
overvalued.

Financial sector reforms should be accelerated in line with FSAP
recommendations to mitigate macro-financial risks, including related to
the rapid growth of credit. Financial sector supervision should be
strengthened, building on the recent amendments to several aspects of
the regulatory framework. Macro-prudential measures introduced in the
aftermath of the 2010-11 episode of financial sector pressures to
contain credit growth have served Nepal well and should be maintained
after the temporary relief granted in February lapses in July.

1
Under Article IV of the IMF's Articles of Agreement, the IMF holds
bilateral discussions with members, usually every year. A staff
team visits the country, collects economic and financial
information, and discusses with officials the country's economic
developments and policies. On return to headquarters, the staff
prepares a report, which forms the basis for discussion by the
Executive Board.

2
The Executive Board takes decisions under its lapse-of-time
procedure when the Board agrees that a proposal can be considered
without convening formal discussions.